Bitcoin or Bust… How far can Bitcoin change the financial markets…

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Bitcoin or Bust… How far can Bitcoin change the financial markets…

After a good 6 months of research into Bitcoin, here are my thoughts and findings. I am very open to comments and thoughts but just thought I would share…

Bitcoin or Bust? How far can Bitcoin change the financial markets…

By Peter Bailey  submitted (Jan 2014)

Executive summary

Bitcoin has changed the financial markets forever but not without its own problem. This report provides a background on virtual currency, key arguments for being mainstream and problems it needs to resolve, finishing with key recommendations on how it can solve its problems. In these findings I will conclude that in order for bitcoin to become mainstream it will need to tackle the fundamental issues with its structural underpinning and reputation as a currency. Governments will also need to intervene with policies to: increase the security standards, strengthen legislation against individuals involved and buying from companies like the ‘silk road’ and stop bitcoin being used as a short win for investors through taxation.

Introduction

In this report I will argue why bitcoin could be the beginning of a new financial revolution.  Initially, I will give some background on the virtual currencies more generically before honing in on some of the key things that make bitcoin’s developments in virtual currency vital to its future. I will then give some key benefits to virtual currency followed by societal recommendations and comments as to how the virtual currency could be adopted as a mainstream currency and the effect this will have on its development.

Background

The financial sector is the latest sector to be targeted by the power of technology but with the roots of currency dating back through the ages, with metal objects (coins) being introduced in 5000 B.C. (Bellis, 2013), there is understandable concerns.

Virtual currency became famous through currency within online gaming sites such as second life, cyworld and Weblo. (Shin, 2008) More recently Bitcoin has taken the limelight with it’s purely peer-to-peer electronic cash system  (Nakamoto, 2008)

Why is Bitcoin the Virtual Currency Leader

Bitcoin has now become an eponym for virtual currencies, after starting out as a hobby for technology enthusiasts “mining” (using computer power to solve a mathematical formal in return for bitcoins in payment) coins (The Economist, 2013), it became infamous through its association with transactions of illegal goods on sites like the ‘silk road’ (BBC News, 2013). Further interest grew in the currency after discussion overs regulation (Carper, 2013) (Rose, 2013), safety (Samani, 2013) (BBC News, 2013) and general hype around growing valuations (Woo, 2013) led to huge speculation and fluctuations in the currency. (Holliday, 2013) These huge flucatations led to interest from investors, likening its trade more to a commodity than a currency. (Slade, 2013)

Why was it designed?

Bitcoin was originally envisioned to tackle the issues of double spending (making a copy of the digital token of the currency and then spending it again (Staff, 2013)) of virtual currency without the use of trusted third party.  (Nakamoto, 2008) The process by which it does this is complex however the basic principle is that each transaction is recorded centrally to the block chain from which all future transactions are checked against that chain. (En.bitcoin.it, 2013) Stopping double spending allows the growth and adoption of virtual currency as illegitimate users can’t undermine the network by spending currency more than once.

Strategic Value

Virtual Currencies and in particular bitcoins have a number of strategic values:

  1. They prove that currency can be run outside of government and financial institution control, whether they are run well or not at the moment is not the point but simply that it is possible.
  2. Virtual currency in gaming increases the value and stickiness to the game as a part of the whole escapism experience (Tvtropes.org, 2014) that has become such a big part of the society.
  3. They are one of the few examples of the successful implementation of the collaborative economy.

What are the key arguments for implementing virtual currencies

Cost

The principle of removing a third party has the benefit of reduced value add in the chain and therefore opportunity for reduced transaction cost. (En.bitcoin.it, 2013) This has a clear benefit to sellers as mainstream peer-to-peer transaction platforms have transaction charges such as paypal (3.4%-1.4% + 20p) (Paypal.com, 2013) and Stripe (2.4% + 20p) (Stripe.com, 2013).

Furthermore, the principle of one single de-centralised worldwide currency would mean there were no transaction charges or fluctuations when buying or selling products and services with different countries. However, some may argue this principle is flawed in that as currently there are no known legitimate companies that pay in bitcoins. Therefore national currency is still transferred into bitcoins making it reliant on government run currency. If however companies were able to pay in bitcoins, ignoring the current factors making it unlikely, it could gain these benefits.

Gold around the Gold Mine

As the network has continued to expand a number of complementary and support companies operating around the peripheries has increased with it. These companies have come in to tackle everything from accessibility of less tech savvy consumers, Blockchain.info for example, to the latest news on virtual currency, Coindesk.com. These companies are absolutely vital to the networks growth as they provide more consumers with the ability to interact with the network, as well as providing more legitimacy to virtual currency as a concept when companies like Coindesk and Opencoin raise $25million (Hajdarbegovic, 2013) and $2 million (Needleman and Ante, 2013) from venture capital respectively.

Beyond legitimacy there is a wider societal benefit to these surrounding companies as they create jobs, which is extremely valuable in the current economic climate. Arguably, the people in these jobs are highly skilled and therefore more than likely to get other jobs elsewhere if they wanted them.

There are also wider benefits as hardware, like the bitcoin mining cards (Butterflylabs.com, 2013),  are designed and improved as companies and individuals drive to ‘mine’ in a more efficient manner to maximise returns.  There are possibilities that these new products may be able to apply to other industries in particular big data where efficiency of computer processing is vital.

What are the key challenges implementing virtual currencies

Bitcoin as a currency or commodity has a number of issues that will need to be tackled in order for it to become mainstream.

Structural Underpinning

As mentioned the core reason bitcoin was created was to solve double spending. An overview of an issue of the structural process of checking for double spending, according to the economist (2013), is that the underpinning processor power required is growing at an exponential rate and will continue to do so as the number of transactions on the network increases.  To put the amount of power currently required into context the current level is 50,000 petaflops or 100 times the performance of the world’s top 500 supercomputers. (The Economist, 2013) This is an incredible amount of data considering the number of transactions is currently around 70,000 (Blockchain.info, 2013) compared to 18,000,000 debit card transactions per day in the UK alone. (Butterworth, 2010) This number of transactions still doesn’t take into account credit card transactions or worldwide transactions making mainstream usage unviable unless it is solved.

Whilst the difficulty mining is increasing at an almost exponential rate (Bitcoindifficulty.com, 2013) leading to the reward for mining becoming more and more difficult to get as the network grows. In summary this means that overtime the potential profit on mining will continually decrease unless the value of the currency keeps increasing through speculation as it is at the moment. This fundamental flaw is likely to cause bitcoin to fail unless the advocates of the currency can change the structure of it.

Further to this, bitcoin also currently is totally reliant on trust within the network as if a payment is made there is currently no method of refund. For bitcoin to become mainstream, this along with a number of other features would need to be introduced to make it more customer friendly as we have become used to in other current banking services.

Security

A further flaw is in regards to security within the network, which could be directly correlated with sub-optimal security generically online (Graziano, 2013).

In particular, the cases of some bitcoin “wallets” (A service that allows you to send and receive bitcoins with others (Bitcoin.org, 2013)) current security vulnerabilities which have been exploited from a number of targeted DDOS (distributed denial-of-service) attacks from cyber criminals leading to more than $3 million going missing. (Southurst, 2013) The continuation of these type of attack will ultimately led to the failure of bitcoin as both a mainstream currency and commodity as currently users see it as novel addition rather than a dependable like national currency. The way in which governments have tried to reduce these risks in banking, the equivalent institution to wallets with national currency, is through legislation, something that bitcoin users are often strongly against. (Ver, 2013) In order for bitcoin to become widely accepted in society either bitcoin and its complementary companies would need to be regulated, in order to maintain a higher standard of security across the network or across the board security would need to be co-ordinated by the network to make sure it is secure. From the two options the most likely to solve the problem is government legislation as they have experience from the banking industry.

Reputation in society

Bitcoins reputation as the society’s underbelly payment transaction base would be one key area that would come more and more into question.  With press articles suggesting that it is the FBI and other security services verus the ‘dark web’ (An anonymous, virtually untraceable unsearchable section of the internet)(BBC News, 2012) and websites like the Silk Road, both operating with bitcoin, with the underbelly currently winning.  (BBC online, 2013) This begins to bring into question whether the governments and institutions will react as they did with Napster (Deas, 2001) in closing down or challenging services because it is facilitating illegal activity rather than being illegal.  At this stage it is difficult to say the level and nature of government intervention with positive tone towards the technology matched caution and lack of understanding in US senate. (BBC News, 2013)

An example of this is around taxation firstly many bitcoin users, as with many other peer-to-peer transactions (online or offline), are not stating them for tax purposes. This is a challenging area for governments to thoroughly trace relying on the goodwill of people writing in tax forms. Furthermore, the current societial view on bitcoin is that transactions can’t be traced. However, governments may see, the totally open transaction records that make it unique (Nakamoto, 2008), as an opportunity to track transactions as part of a bigger smart data set that can be used to calculate tax and many other areas.

Further than this, the huge capital gains that some investors have made from buying and selling bitcoins brings into question whether bitcoin are taxed as income, as other forms of currency, or capital gains,  as other commodities. (En.bitcoin.it, 2013) This is currently a grey area which each country is debating with Canada and Swedish deciding it is a commodity and the US undecided. (Robert A. Green, 2013) If they decide to make it commodity this will further damage bitcoins ability as a currency, due to is unique crowd based characteristics, because if people don’t consider it a currency and use it as such it won’t become a currency.

Is Bitcoin just a Ponzi scheme?

As a commodity Bitcoin provides an opportunity for people who understand the technology and have influence, like the Winklevoss brothers, (Fontevecchia, 2013) to make large profits from the buying and selling of the asset.  Thus creating an environment some would argue resembles that of a Ponzi scheme (Independent.co.uk, 2014) (Marketoracle.co.uk, 2013) making it unmanageable as a currency and undermining the principle of bitcoin being crowd developed and maintained.

Collaborative Economy

The collaborative economy is a term that has been coyed over the last few years that aims to describe an economy built on a distributed network of connected individuals. (Co.Exist, 2013) This concept is in the early stages of development and therefore for economies like bitcoin that rely on it’s principles so heavily, through its mining and advocacy network, it is unclear as to what the growth or fallout potential is.

Technological infrastructure

Behind all of this there is a more fundamental change that would need to happen within society in regards to internet access. Whilst in developed continents the percentage of users is between 60-80%: North America (78.6%), Europe (63.2%) and Austrialisia (67.6%)  the developing contients: Middle East (40.2%), Africa (15.6%) and Asia (27.5%) have a way to catch up. (Internetworldstats.com, 2013) This shows that with only (34.3%) (Internetworldstats.com, 2013) of the world online there is a considerably change needed to get online in order for virtual currency to become mainstream.

How it will add value to the economy

Virtual Currency and in particular the developments of bitcoin would add value to the economy differently to each stakeholder. To governments, through the continued use of blockchain they would have the opportunity to trace all transactions within the economy making it more transparent. This could have a number of benefits to government in tackling fraud, taxation and other issues.

Through the drive for more efficient ways to mine bitcoins it provides a social benefit in pushing technology forward for the benefit of other industries. This could also link into providing more competition to the banks and other organisations into providing better services through its innovations in payment methods. Further to this, the creation of bitcoin as a currency has created a large number of jobs through a whole new ecosystem being created.

To the users of the currency, bitcoin currently provides a cheap transaction base that allows money to be transferred across borders potentially without the need to exchange currency. Furthermore, in the short term it is offering many users the opportunity to get rich quick through its hype raising prices.

Transition and long term issues

In the medium to long term, it is likely that any wider usage would still be as a part of a hybrid system in which people used both national currency and virtual currency. This is due in part to people tending to be risk adverse especially where livelihood comes into play and in part due to the time it would take for business in particular retail to adopt the change. However, it is clear that is possible as some online businesses such as Zynga have taken on bitcoin of a source of currency. (Bloomberg, 2014)

One of the most fascinating aspects of bitcoin in the long term is that in giving recommendations, there is no direct individual or organisation that is accountable for bitcoin therefore; decisions would need to be taken on by the crowd. This challenges current business models that suggest that rapid change or crisis management, both vital in the fast changing environment, can only be dealt with in organisations with simple management structures.

Finally, transitioning into currency provides a number of structural challenges to countries that do not currently have fast and reliable internet access. Without this standard of access, it would be challenging for the currency to be taken mainstream. However, this may give opportunity for the currency to grow more iteratively over time as currency has developed allowing any bugs to be resolved.

Recommendation

The three core recommendations for bitcoin in order for it to become main stream are:

  • The crowd that supports bitcoin needs to modify or adapt the process of the block chain to reduce the level of data needed to be stored whilst maintaining the ability to track transactions.  To allow for a considerable increase in the number of transactions on the network.
  • Governments across the world need a united front to bring in policies to:
    • Increase the security standards expected off bitcoin companies to something more similar to that of the banks.
    • Strengthen legislation against individuals involved and buying from companies like the ‘silk road’.
    • Stop bitcoin being used as a short win for investors through taxation.
  • Finally the users of the currency need to fundamentally change their usage of bitcoins from looking at bitcoin as a commodity to it as a currency.

Communications Strategy

Users of the system need to have a continued clear and unbiased understanding of what is happening within the bitcoin network. This would be achieved through continued up to date information through websites like coindesk and others.

Governments would need to consultant on changes in legislation with the network through blogging platforms and similar in order to truly get a view of what would and would not work in terms of legislation. Another good platform for them to communicate through may be virtual currency conferences and events as it is likely that the enthusiasts that understand and can make changes on the network would be there. Furthermore, governments would need to communicate clearly with the support organisations around bitcoin in order to make sure these organisations embrace the changes to improve the network rather than pull away from it.

Governments would further need to generate clear and defined policies that demonstrate the rules and regulations that have been brought in around bitcoin.


1 Comment

Milton

October 21, 2016 at 6:40 pm

This is one awesome article post.Thanks Again. Will read on…

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